Thursday, 12 September 2013

Failed Banks

The Royal Bank of Scotland and Halifax Bank of Scotland were two of the world's most successful and admired banks until their spectacular failure in the 2008 financial crisis. RBS was bailed out by the government and HBOS was taken over by Lloyds TSB, which in turn had to be bailed out. These recent books by journalists Ray Perman and Iain Martin tell their stories. Both narratives are fast paced and fluently written with plenty of good anecdotes. They are enjoyable reads that illuminate an aspect of the credit crunch. But these accounts are partial, the authors' knowledge of finance is weak and description overwhelms explanation.

The very title of Iain Martin's book conflates the story of RBS with the story of its notorious former CEO Fred Goodwin. He notes that Goodwin has assumed the role of pantomime villain, and there are lots of entertaining and horrifying anecdotes. Martin dishes the dirt, but he provides balance and nuance. Goodwin bullied his staff, but was reluctant to sack them (especially face to face). He tore strips of subordinates, but was nervous of confronting Johnny Cameron, head of the Global Banking and Markets division. Former chairman Bob Mckillop reveals a more constructive relationship with the board than is generally recognised, and Goodwin's successor Stephen Hester is quite generous. But the overall verdict is damning.

At Goodwin's executive Christmas lunch one year there a game "involving assorted bankers dipping a finger in sambuca, one lighting it and then passing around the flame, with the first person to opt out declared a sissy" (p.155; I wonder if it would be wrong to propose that game at my work Christmas lunch this year?). More seriously, the book describes his bullying of subordinates, his insistence that targets are met at any cost and his absurd focus on superficial details like the colour of the bank's corporate Mercedes and the carpet in its offices. But this appalling character eclipses the story of the business he ran.

Many of the Goodwin stories in this book were widely circulated before his downfall. But he was feted as a great leader; he was Forbes' 'Businessman of the Year' and subject of a fawning Harvard Business School case study. Regulators assessed the management of RBS more favourably than that of more conservative Lloyds TSB (p.176). Investors supported his aggressive growth strategies and audacious acquisitions. When Bob McKillop talked to fund managers after assuming the RBS chairmanship he was given a clear message that the shareholders valued Fred Goodwin. People often accept bad behaviour when it generates good results. Steve Jobs was regarded as a bully and a perfectionist too, but Apple prospered so he is still seen as a role model. Indeed, his character is taken as a explanation for Apple's success just as Goodwin's (similar) character is now taken as an explanation for RBS's failure.

The focus on personality means that other reasons for the RBS collapse are downplayed. The biggest single factor was the disastrous ABM Amro acquisition; an assessment of the bank's prospects without ABN would have been interesting. The Bank followed a similar growth strategy to many of its rivals, but there is no assessment of RBS's relative performance on a stand-alone basis. The discussion of the regulator's failure to challenge its strategy is superficial, and there is no account of why investors backed it so willingly. The story of RBS is sui generis, but the explanation of its collapse involves factors common to the entire industry - many of which are abstract and complex and don't make for a good narrative.

The book works as an extended feature article about Fred Goodwin, but Martin spoils it by trying to address wider questions of bank regulation that he scarcely understands. He mentions the Efficient Market Hypothesis, but he doesn't know what it is (it does not hold that investors will act wholly rationally if they have access to the same information - p.313). His understanding of Value at Risk is sketchy - it's not a measure of risk to the whole balance sheet, as Martin implies (p.220). He describes the process of using retail deposits to fund the wholesale bank by saying that vans came around the branches to collect the money for head office (p.62). The reality is less literal. He wants smaller banks to avoid the 'too big to fail' problem, but doesn't address the risk of systemic failure by a large number of smaller firms (like the savings and loans crisis in the US).

The most insightful and interesting part of the book is the account of Martin's discussion with Stephen Hester, which explains the background to his recent surprise departure from the bank. Hester is better than Martin at summing up RBS's failure. The attributed quotes from Hester are revealing of the book's reliance on interviews with biased internal sources with a personal interest in heaping blame on Goodwin to exonerate themselves. It makes it hard to second-guess Martin's narrative, because only he had access to those sources and only he has the interview notes. The book is sparsely referenced, which means we have to take the narrative on trust. It also means that we should be especially cautious of its account, and accept that there is still a lot of uncertainty about what really went on.

Perman's book about HBOS also focuses on personalities, but the personalities are smaller and the anecdotes less compelling. Perman is also more insistent with his wrong-headed prescriptions about banking, contrasting aggressive practices of the go-go years with a golden age of decent banking that is in fact wholly mythical. The book suffers from a surfeit of errors of fact and of understanding; Perman especially struggles when he tries to explain securitisation. He thinks that bankers used to borrow long term and lend short term (their role has always been exactly the opposite). He thinks that sub-prime mortgage securities were never rated AAA (they were deliberately structured to ensure AAA ratings). He thinks that HBOS fared little better than RBS in its rights issue (HBOS take-up was under 9%, RBS was 100%).

Perman's romanticisation of old-fashioned banking is pure hokum. Old-fashioned banking was just as prone to crises, and it was much worse at providing credit to worthy borrowers. An old hand at one Scottish bank once told me that when he started out in banking his boss told him to follow the 'three Cs': "never lend to coons, Catholics or council house tenants". When branch managers had to rely on their instincts this kind of prejudice was widespread, if rarely expressed so crudely. The credit scoring systems that Perman scorns consistently perform better than 'expert' human judgment in retail lending decisions. |But Perman makes no attempt to consider contrary evidence, or even to argue for turning the clock back. He simply presents it as an obvious improvement that needs no justification.

The book is not wholly without merit. It debunks the popular myth that Lloyds TSB was forced by the government to take over HBOS and it describes the institutional politics well. But it has the same faults of partiality as Martin's book, plus a few more all of its own.

These books are enjoyable tales about the institutional politics at two banks at the centre of the credit crunch. But they are partial accounts relying on biased sources, and both authors struggle to explain the wider context of these firms' failures. It's easy and reassuring to see the financial crisis as the outcome of bad decisions by corrupt or incompetent individuals. It gives us people to blame, and it implies simple prescriptions for avoiding future crises. There were corrupt and incompetent people, and their stories should be told. But those stories should not be mistaken for explanations of the credit crunch.

[Full disclosure: the author works for RBS and previously worked for Lloyds, which bought HBOS. This review is written in a personal capacity.]